Mumbai: The minimum mandatory amount of deposits that banks need to set aside to invest in government bonds need to come down gradually, said Reserve Bank of India governor Duvvuri Subbarao on Tuesday, sparking concerns of excess supply of gilts in the secondary market.

The Reserve Bank of India (RBI) has mandated banks to set aside a portion of their deposits as statutory liquidity ratio (SLR) or the minimum amount it must hold in gold, cash or government bonds. In addition, banks have to set aside a portion of their deposits as cash with the central bank, a requirement called the cash reserve ratio.

These reserves can act as a liquidity buffer for banks during crisis time.

“SLR at 24%, CRR at 6% is still considered high. At some point it (CRR, SLR combined) was 65% and now it is 30%," said RBI Governor Duvvuri Subbarao in his address at the National Finance Symposium organised by the Indian Institute of Foreign Trade.

“It is our objective in RBI to bring it down but in a calibrated way."

Government bond yields rose after Subbarao’s comments on the need to lower SLR on concerns that such a move could prompt banks to offload some of their bond holdings. The minimum regulatory requirement acts a captive demand for government bonds.

The 10-year Indian benchmark bond yield rose by one basis point to 8.29% after the comment. It closed at 8.28% on Monday.

“Though it is RBI’s medium term goal to reduce SLR and CRR, in a knee-jerk reaction, yields went up as they (traders) were worried that RBI may cut SLR to infuse liquidity," said a dealer at a foreign bank.

Currently banks’ overall holding of SLR bonds is around 29%, according to analysts.

The central bank had last reduced the SLR by on percentage point to 24%, effective 18 December, 2010, to ease acute tightness in liquidity.

Subbarao said that the SLR requirement had help protect Indian banks during the global credit crisis and the new global banking rules under Basel III have a provision which mimics the SLR rule.

Yet, the central bank chief said that some reduction in the ratio may be needed.

“We should bring it (SLR) down so that credit is available and so that private sector is not crowded out," Subbarao said on the sidelines of the event.

The RBI has also not tinkered with CRR since April 2010, when it had last raised the reserve ratio by 25 basis points to 6%.

The RBI governor also said that the central bank is looking at relaunching inflation indexed bonds.

“We are looking at reintroducing inflation indexed bonds. One concern of course is, in a period of relatively high inflation that we now have, whether it will be successful. We will think through this, but we will certainly introduce it."

Inflation indexed bonds are floating rate bonds linked to the inflation rate and such bonds help investors to shield their investments from mark-to-market volatility.

However, an investor will be interested in buying such bonds only when they expect inflation to rise further going ahead unlike now, when most expect prices to cool off in next few months.